Banks That'll Rise with Rate Hikes

Forget popular wisdom -- some bank stocks do just fine as interest rates climb, say S&P analysts Evan Momios and James O'Brien

The conventional wisdom is that as interest rates climb, financial stocks will suffer. But Evan Momios and James O'Brien, Standard & Poor's analysts of banking and financial-services stocks, point out that the banking industry is so diverse nowadays that this is no longer necessarily the case. Higher rates are "positive for a wide array of businesses, such as credit-card issuers, for example," says Momios. "But on the other hand, they're negative for companies that specialize in residential mortgages."

So S&P has a variety of bank stocks with buy ratings, including Bank of America (BAC ), Citigroup (C ), and National City (NCC ) among the larger banks covered by Momios, and Commerce Bancorp (CBH ) and SouthTrust (SOTR ) in the smaller category O'Brien follows.

On the trend toward bank consolidation, Momios notes that the number of depository institutions in the U.S. is down from just over 15,000 in 1990 to a little over 8,000 today. And takeover speculation is part of the explanation for higher price-earnings ratios for smaller banks, which leaves many large-cap banks looking like better values.

These were some of the key points Momios and O'Brien made in an investing chat presented Sept. 7 by BusinessWeek Online and Standard & Poor's on America Online, in response to questions from the audience and from BW Online's Karyn McCormack. Edited excerpts follow. A full transcript is available from BusinessWeek Online on AOL at keyword: BW Talk.

Note: Evan Momios and James O'Brien are Standard & Poor's Equity Analysts. They have no ownership interest in or affiliation with any of the companies under discussion in this chat. All of the views expressed in this chat accurately reflect the analysts' personal views regarding any and all of the subject securities or issuers. No part of the analysts' compensation was, is, or will be, directly or indirectly, related to the specific recommendations or views expressed in this chat. For required disclosure information and price charts for all S&P STARSS-ranked companies, go to spsecurities.com and click on "Investment Research," and then click on "Required Disclosures & Standard & Poor's STARSS vs. Closing Prices Charts."

Q: Now that many market professionals are back after the summer break, do you see market volumes picking up? And what's S&P's outlook for the market for the next few months?

Momios

: The market was weak in August, as is usually the case. Today we saw good performance in the market and the financial-services area, probably because of the slide in the price of oil and the fact that the Republican National Convention was completed without any terrorist incidents. Going forward, there are uncertainties -- the elections, of course, are one, and the economy, which in recent months appeared to be in a soft patch. We may see a small pickup in activity in the next couple of weeks, but we don't expect any significant moves in major indexes until the end of this year.

Q: How will higher interest rates affect the companies you follow?

Momios

: The banks nowadays are not one group any more...the bank sector is very diverse, and it's hard to say that higher interest rates are either good or bad for financial-services companies in general. So the impact of higher interest rates, and what we are talking about here is higher short-term interest rates, varies depending on the focus of each company.

For example, although higher interest rates are traditionally viewed as a negative for financial-services companies, they're positive for a wide array of businesses, such as credit-card issuers, for example. But on the other hand, they are negative for companies that specialize in residential mortgages.

Q: Your thoughts on Wells Fargo (WFC )?

Momios

: Well Fargo is a well-managed company. We rate it a hold.... We like WFC's strong sales culture, product diversity, solid credit quality, and its high-growth geographic markets. But we think all of those positives are reflected in the stock's premium valuation relative to other large-capitalization banks.

Q: Bank of America (BAC ), J.P. Morgan Chase (JPM ), or Citigroup (C ) -- which stock would you pick if only one stock could be bought?

Momios

: That's a question that I cannot answer. What I can tell you is that we have a buy recommendation on Citigroup and Bank of America, and we have an accumulate recommendation on J.P. Morgan Chase.... For both J.P. Morgan Chase and Bank of America, we think a lot of the stock performance, and the company performance, going forward will depend on how well the two integrate acquired institutions. For Citigroup, we think the driver will be general global economic conditions and whether or not legal risk remains under control.

Q: What is wrong with Fifth Third Bancorp (FITB )?

Momios

: From our point of view, we don't think that anything is really wrong in the long term. This is a high-performing bank that has traditionally traded at a very high multiple vs. its peers. We think the stock will expand toward that historic multiple over the next year. There are some concerns by investors on the impact of higher interest rates on the company's net interest margin, but in our view, those concerns are exaggerated. We rate FITB a 5 STARS (buy).

Q: Do you see AmSouth (ASO ) as a potential takeover? Do you see more consolidation in general?

Momios:

AmSouth is rated a 4 STARS (accumulate).... We don't usually make recommendations based on acquisition speculation, but the fact is that AmSouth operates in attractive geographic markets, and its wealth-management and commercial-banking businesses have, in our opinon, high growth prospects. In reference to the acquisition speculation, it's something that really affects smaller-capitalization names, and James will talk about that in more detail. What I can say is that the number of depository institutions operating in the U.S. was over 15,000 in 1990 and currently is a little over 8,000. O'Brien: From a valuation perspective, small-cap banks are trading at a one- to two-point p-e premium to their larger-cap brethren. Some industry observers have reasoned that part of the disparity comes from the fact that many small banks may be bought up by larger entities. Attractive acquisition candidates appear to be operating in desirable growth areas that are based on deposit growth, population growth, and economic growth in various parts of the country, such as the Southeast, Texas, and parts of the West.

We believe many smaller to midsize banks will sell themselves because of their inability to keep growing earnings, due to their lack of product depth, technological absence in some cases, or desire by senior management to do something else.

Q: How high is BB&T (BBT ) going?

O'Brien

: We currently rate BB&T 3 STARS, which is a hold rating in our system. We have a $39 price target on BB&T, roughly where the stock is trading today. The reason for our hold recommendation is that we believe loan growth outside its retail market is likely to remain below its historical trends, with demand in the back half of 2004 still uncertain. Also, we believe expense growth has not slowed down sufficiently enough since the integration of First Virginia Bank.

Q: What's your view on National City (NCC )?

Momios

: National City is a company currently rated a 5 STARS [buy], with a 12-month target price of $42. Year-to-date, it has been one of the best-performing companies in our coverage universe. We believe that excluding some of its mortgage business, the rest of the company should generate double-digit revenue and earnings growth if economic conditions remain strong. We like the higher-than-average dividend yield that the stock offers. And we also like the company's progress in improving the risk profile of its loan portfolio and keeping expenses under control.

Q: What are your thoughts on Washington Mutual (WM )?

O'Brien

: We currently rate WM 3 STARS (hold). We have a $38 price target, which is slightly below today's closing price. Some of the basis for our hold recommendation is that we expect the net interest margin to narrow. We also see noninterest income falling significantly, based on our projection of lower security gains and mortgage-banking income. We also forecast operating expenses to be up due to expansion spending that will outpace lower costs associated with reduced mortgage volumes.... We would recommend investors not add to positions at this time.

Q: Do you have an opinion on First Republic Bank (FRC )?

O'Brien

: We currently have a 3-STARS rating on FRC and a $45 price target. We think the bank continues its transformation into a trust bank with a high-net-worth market focus. We think in the second quarter our outlook became more positive, based on the fact results were aided by asset growth, fee income growth, and controlled expenses.

Q: What are your favorite 5-STARS (buy) ranked stocks in the small-banks area?

O'Brien

: Currently, my two highest-rated stocks are Commerce Bancorp (CBH ) and SouthTrust (SOTR ). I have an $80 price target on CBH. We believe that this is a controversial name at this point in time, and investors currently appear to be valuing the bank based upon the headline risk associated with the recent indictment of two of its employees. However, in our opinion, based on the strong fundamental retail franchise the bank has created, it's light years ahead of the competition, in our opinion.... Strong core deposit growth -- nearly four to fives times faster than the industry average -- is what will continue to drive 20%-plus top- and bottom-line growth for the bank over the next few quarters.

On our other top-rated pick, SouthTrust, we have a $48 12-month price target. Our recommendation and price target are currently tied to our recommendation and price target for Wachovia (W ), as SouthTrust has been acquired by Wachovia and is scheduled to close some time in the end of 2004, pending regulatory approvals.

Q: Outlook and possible acquisition scenario for North Fork Bancorp (NFB )?

Momios

: North Fork has been repeatedly mentioned in the news as a possible acquisition target. As we mentioned earlier, we don't make recommendations based on such rumors. We do think North Fork is a fundamentally strong regional bank with superior operating profitability. It has agreed to acquire GreenPoint Financial (GPT ), and in May, it acquired the Trust Company of New Jersey.

We have a mixed view of the proposed GPT acquisition, which may have a somewhat negative impact on NFB's currently wide lending margins and also could increase interest-rate risk. Overall, we are rating NFB a hold.

Q: The p-e ratios of the banks are very low -- how much expansion do you see? Do you see bank stocks performing better than the market?

Momios

: They are not low, particularly among smaller banks, which are at 91% of the S&P 500-stock index average and at the top end of the 30-year historical range. So if anything, smaller banks look expensive on a p-e basis using '04 estimates.

Now, if we look at larger banks, the average p-e there is 12 to 13 times '04 estimates. For example, companies like Bank of America (rated buy), Citigroup (also a buy), National City (buy), and Wachovia (buy) all have p-e multiples around 12 times our '04 estimates. So that partly explains our preference toward larger-cap names at this point in time. I think James agrees with me that some of the explanation for why we see larger multiples in smaller banks is the view that smaller banks can be acquisition targets.

Edited by Jack Dierdorff

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